Question

Consider two firms, A and B. Firm A is a US-based company and firm B is a Germany-based company. Firm A wants to finance a 10-year, €100 million project in Germany. Firm B wants to finance a 10-year, $111 million project in the US. The current spot rate is $1.11/€. Their borrowing opportunities are given in the table below:

	US dollar	Euro
Firm A	4.00%	2.70%
Firm B	5.00%	1.80%

1. Calculate the quality spread differential (QSD) between Firm A and Firm B.

2. Develop a cross-currency interest rate swap in which both Firm A and Firm B have an equal cost savings in their borrowing costs, and the swap bank makes 0.30% per annum in arranging the swap and assuming all foreign exchange risks.

3. Illustrate your swap and its cash flows by drawing the proper swap diagrams showing the swap interest rates, and the cash flows at the initiation of the swap, at each annual settlement during the life of the swap, and at maturity of the swap.

Answer 1

Firm A = US-based Company

Firm B = Germany based Company

current spot rate = $1.11/€

Notional Principal = $111 million or €100 million

Since Firm A has an advantage in US dollar and Firm B has an advantage in Euro, therefor Firm A will finance loan in US and Firm B will finance loan in Euro.

a = difference between the interest rate facing for two firms in the US market

b = difference between the interest rate facing for two firms in the German market

a = 5-4 = 1%

b = 1.8 - 2.7 = -0.9%

1. QSD = 1 + 0.9 = 1.9%

3.

Cash Flow for Firm A

a. Firm A will pay 4% in the dollar to outside lender

b. Firm A will receive 4% in the dollar from Swap Bank

c. Firm A will pay 1.9% in Euro to Swap Bank.

Cash Flow for Firm B

a. Firm B will pay 1.8% in the Euro to outside lender

b. Firm B will receive 1.8% in the Euro from Swap Bank

c. Firm B will pay 4.2% in Dollar to Swap Bank.

The Swap diagram is in the pic attached